As the size of the ETF lineup has sped toward 1,300, more specialized and targeted products have been hitting the market. While most ETF assets are in “plain vanilla” funds offering exposure to well-known benchmarks, the ETF roster is now filled with dozens of hyper-targeted products offering exposure to exotic and sophisticated asset classes and investment strategies. For every SPY there is a handful of ETPs such as the Daily 2x VIX Short Term ETN (TVIX), IQ Hedge Macro Tracker ETF (MCRO) or 2x Oil Bull S&P 500 Bear (FOL).
One of the more unique products in the ETP universe has actually been around for more than three years. The iPath Global Carbon ETN (GRN) debuted in June 2008. This exchange-traded note is linked to the Barclays Capital Global Carbon Index Total Return Index - a benchmark that likely isn’t recognized by a whole lot of investors. The underlying assets are carbon allowances: credits that essentially allow companies to emit specified levels of carbon from factories and power stations.
Carbon cap and trade programs have been the subject of significant debate in the U.S. in recent years, and are used more widely at present in Europe. The basic mechanism of the program is relatively straightforward (iPath has a nice brochure with more detailed information):
- A cap for emissions of certain substances is set by the government
- Carbon allowances are issued that allow for the specified level of emissions
- Firms that do not submit carbon credits to cover their actual level of emissions face financial penalties
- Firms that emit less than their allowed level are free to sell carbon credits in an open market
That structure is designed to entice firms to cut back on emissions, since doing so will enable them to generate revenue through the sale of carbon allowances to firms that emit more than their allowed level.
GRN is linked to an index that consists of multiple types of carbon emission credits: the European Union Emission Trading Scheme (EU ETS) Phase II and Kyoto Protocol’s Clean Development Mechanism. As such, this ETN gives investors a way to quickly and easily trade carbon credits that have become a part of the European regulatory landscape - at least for the time being.
Behind GRN’s Freefall
Valuing carbon credits can be a tricky task. There are a number of different factors that go into determining the levels of supply and demand for these allowances. The ETN offering exposure to this unique asset class attracted some attention last month when it sank nearly 25%, making GRN one of the worst performers in the ETP universe in June. The freefall has attracted the interest of some bargain hunters looking to scoop up beaten down securities. But to understand if GRN is a value, we must take a closer look at the factors that hammered the price during June.
Concerns about Greece’s deteriorating fiscal health weighed on the carbon credit market in the month since slower economic growth translates into lower industrial activity and therefore less of a need for additional carbon credits among certain factories that may otherwise cross their determined threshold. But carbon credit markets continued to plummet even after approval of an austerity plan sent global equity markets up sharply. As Christopher Cundy notes, several other factors contributed to the free fall as well. Poland rejected a low carbon roadmap that would have reduced emissions by 2050, taking away some demand that had been expected going forward. An EU vote on the specifics of Phase III of EU ETS, which will begin in 2013, resulted in greater-than-expected supply of allowances that will become available later this week. Cuddy also notes that utilities, historically a major buyer of allowances, have held off on purchases as they are not hedging forward power sales as had been expected.
There has also been some uncertainty over the future of the market for carbon credits; if climate change negotiations cannot be wrapped up by the time the existing Kyoto Protocol lapses at the end of 2012, the status of the Clean Development Mechanism through which credits are traded could be in doubt.
There are, perhaps, reasons to be bullish that the carbon credit market will snap back. Some note that utilities may have an interest in keeping carbon credit prices elevated in order to charge higher prices for power. And with the EU planning to fund a series of clean energy products through the sale of carbon credits, other parties have an interest in elevated prices for the right to emit carbon.
GRN may be intriguing for those who believe the steep drop in carbon credit prices has been an aberration. But there are reasons to be cautious when considering this fund. GRN trades infrequently; during several June sessions, not a single share changed hands. So anyone considering a position would be wise to use a limit order to buy or sell.
Disclosure: No positions at time of writing.
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